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May 29, 2012

Why to invest in debt funds because of falling interest rates?

After the crash of market in the year 2008, market has become volatile globally. There is insecurity looming large over where to invest and how to save money for hey days. Nothing seems secure and assured source of income.

Globally there is much talk about investment in debt funds, financial planners see it as a risk free investment option with a guaranteed return, though not big but there is an assurance that you would get a little higher than whatever was invested as capital.
Why debt fund?
With debt fund the biggest advantage is you can make an exit and entry anytime you want. The main characteristics of the debt fund is it is form of investment done in bonds as government or corporate, or debentures and others. In addition the return on these investments is at par with bank deposits, so you can expect a return of 8 to 9 % annually.
Debt fund are funds which are invested in long, medium or short term income. They are the most unchallenging and stress-free form of investment as there is continuous return and it is not affected by the volatility of the market, rather when the interest falls it is adversely affected and gives considerably good return with falling interest rates. 
A change…
The current economic situation has put much stress on the banking system of a country. So the investors are seeing an opportunity in making investment which is bound by time horizon and starts with investment for at least 3 months, and has an average maturity period in between 6 to 12 months.
However, there is one more constraint with an investment on debt fund with one year period. This time would not be advisable for those who are looking for assurance on return on invested capital in one year horizon. Thus, the better alternative is, invest in good quality corporate bonds. This would yield better return on investment in today's volatile interest rates. As has been seen, yield on corporate debt instruments are reasonably high, they adequately compensate for inflation and are free of credit risk.
How?
Take a hypothetical situation, with treasury rates at 8.5% and the 2/3 year AA corporate bond spread at 1.5% that is a 10%-11% yield from a high quality borrower, the earnings yield from a alike company would be lower than expected. But if the business environment has worsened materially a year from at the present, then treasury rates will have decreased, and the on the whole return from this bond would be higher than 10% e.g. a 1% fall in yield, the added return would be 2%. If the business environment were to improve then in all probability the bond spread would narrow, also producing a higher than 10% return.
This is what makes investment in debt funds a safer bet for someone who wants to avoid risk and want guaranteed return on investment. It is the best risk-reward in the trading market for a period of one year. It gives a fixed income security, with an added advantage of capital appreciation as investors are related with corporate performance via the corporate bond spread.
Investors around the globe have taken this investment plan passionately and there is huge investment happening in the dynamic bond fund and short term funds which are part of debt funds.

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This article is written by Mr. Mayank Gupta who blogs at NineMillionDollars.com and writes on income tax and mutual funds. Click Here

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